Saturday, May 11, 2019

Burton Malkiel's design of a newsletter scam

Start 16 newsletters. In 8 of them, scream for a year that Nifty will go up, and in 8 of them, do the opposite.

At the end of year 1, you have 8 successful newsletters. Close down the losers. Now repeat this, with 4 forecasting up and 4 forecasting down.

At the end of year 2, you have 4 successful newsletters, shut down the others.

At the end of year 3, you have 2 successful newsletters.

At the end of year 4, you are solid gold: you are holding one newsletter which correctly timed the market for 4 years in a row. Now make a lot of money selling subscriptions to this newsletter.

While this is a neat design of a scam, the world is actually, inadvertently, running something like this. A large number of newsletters are born every year. Some of them are lucky, they forecast the market correctly, and they stay alive. The losers tend to shut down.

At every point in time, you see a pool of successful newsletters. This need not imply that they have forecasting capabilities. It could just be survivorship bias at work.

Fund management

This same idea would work in fund management. You could start 16 funds, and at the end of 4 years, you would be holding 1 fund with a remarkable track record. This is possible even if you have no ability to forecast asset prices at all.

Once again, the world is actually running such a system. A large number of money managers spring up all the time. When the bets don't work out, the organisation collapses. The survivors stay in the game.

The world is initiating much more than 16 funds. Thousands of fund managers take a stab at the trade. It is not surprising that at any point in time, we see five or ten of them with five or ten years of a successful track record. While some ability may exist in the world, there is certainly a simple process of survivorship bias going on, which generates a few fund managers with a good track record.

Bellwether constituencies

Suppose you have 500 constituencies, and suppose all election outcomes are roughly 50/50. That is, there are exactly two parties and they each win about half the seats. Suppose that in truth, the outcome of each constituency is completely random and it is just like tossing a coin.

At the end of one election, you have 250 constituencies where the winner of the overall election won.

At the end of two elections, you will have 125 constituencies which were with the winner for two elections in a row.

At the end of three elections, there will be 62. At the end of four elections there will be 31.

This tells us that if we see about 30 constituencies in India, where the winner in each of these constituencies was the ruling coalition that came out of the Lok Sabha elections for 1999, 2004, 2009, and 2014, this might just be simple randomness at work. There may be nothing special about these `bellwether constituencies'.

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